Investment is the value of machinery, plants, and buildings that are bought
by firms for production purposes.

Investment
plays six macroeconomic roles:
1. it contributes to current demand of capital goods, thus it increases
domestic expenditure;
2. it enlarges the production base (installed capital), increasing production
capacity;
3. it modernizes production processes, improving cost effectiveness;
4. it reduces the labour needs per unit of output, thus potentially
producing higher productivity and lower
employment;
5. it allows for the production of new and improved products, increasing
value added in production;
6. it incorporates international world-class innovations
and quality standards, briging the gap with
more advanced countries and helping exports
and an active participation to international trade.

Composition

Although capital accumulation takes place in many institutional sectors
of the economy (firms, households, public sector, ), a narrower definition
is used in national accountancy.

Investment is just
new capital accumulation in business (both private and state-owned).

Household by convention
do not invest, even if it does exist a capital accumulation in cars, computers,
electric appliances, etc.
that we include in their "cumulative
bundle".

Public
expenditure is partly devoted to roads, railways, infrastructure,
buildings (as for schools, hospitals, ). All this is clearly capital
accumulation whose utility will last over time. Still, it is quite a common
practice for investment in public sector being considered zero by convention.

Investment is classified according to the degree of directness
with which it is linked to current and future sales:

1.
inventories stock of finished goods, semi-manufactured goods, and
raw materials in commercial premises, storehouses and producers' plants;
2. equipment for direct production of services and goods;
3. transport and auxiliary machineries;
4. office and general endowment for indirect workers and management;
5. any long-lasting improvement in those items;
6. industrial plants and service buildings;
7. other buildings.

In
today's world, investment in immaterial assets is getting more
and more important, as with the case of expenditure in Research &
Development, human capital, software and other areas.

Financial investments
in shares, obligations and other financial instruments are not considered
as "investment" in a macroeconomic sense nor in national accountancy.
The same is true for real estate exchanges of used buildings (both residential
and non-residential).

At firm level, investment is determined by expected benefits as
well as funds, both in term of availability and cost (interest
rate).

Benefits relate to
the effects of investment in terms of increased value added, reduced costs,
larger production, higher competitiveness. Hence, profits
are expected to be higher, too. The value over time of these benefits
(and profits in particular) are compared to the investment costs.

The temporal profile of costs and revenues will be important in the decision
whether to undertake the investment or not.

1.
self-financing, in turn due to:1.1. cumulated
past profits;
1.2. injection of new financial capital from the owners;
1.3. amortization, i.e. accountancy allowance for past investment, considered
now as current costs but not corresponding to
any current expenditure;
1.4. extension of equity by new shareholders, as it happens with relatives
sending remittances to home business;

2.
loans from banks and other financial institutions:
2.1. long-term credit at fixed or variable interest
rate in domestic or foreing currency;
2.2. short-term credit;
2.3. micro-credit in the case of very small
business;

3.
capital market finance, through the emission of obligations as well as
through the issue of shares in the stock market (primary market). The
following price fluctuation do not directly have any impact on financing
the firm. But it is true that further new emissions of shares often require
positively-oriented capital markets.

5.
public funds and incentives for investment from international, national,
regional, local institutions.

However, the empirical evidence of microdata shows thatinvestment - at micro level - is infrequent and lumpy. There are
periods in which firms decide not to invest and periods of large investment
episodes. For better understand the issues at stake see this
paper.

Investment expenditure is a bet on future. If the bet is lost, the product
does not find a remunerative market and much of the investment expenditure
turns out to be a sunk cost that cannot be
recovered. In the extreme case, investment is irreversible. Coupled with
true uncertainty, irreversibility becomes a fairly important
determinant of investment levels across industries, as this
paper points out.

In the IS-LM
model, interest rates are considered the unique determinant
of investment. In fact, interest rates play three distinct functions:

1.
they influence the discounted value of net benefits over time;
2. they determine the cost of loans from banks and the required rate of
return for the owners and financing institutions;
3. they set the economic climate both for financial and real markets.

In
all three function, a higher interest should trigger a lower investment,
since the present value of benefits will be lower, finance costs higher
and economic perspectives worse.

Still, there exists
investments that are not based on interest rates considerations. For instance,
firms have usually a very restricted number of investment projects, carrying
them out when profitability is well above zero. A small change
in interest rate would have simply no impact
on each investment decision, thus on aggregate level as well.

By contrast, the effect
of large interest rate changes may be highly asymmetric:
a strong increase of interest rate can indeed provoke a fall
in investment dynamics whereas a similar decrease may fail to induce investment,
if real perspective benefits are lacking.

Other determinants
of investment should be considered as, for instance, present and expected
consumption and export.

Saturation of productive
capacity represent a key references for firms' decisions to invest.
Expectations about future sales will affect investment if the current
capacity is not enough to match the forecasted increase in demaned quantities
and the firm is committed to fulfill all orders. Given a ratio of fixed
capital to sales, the investment required would be (in a very simplified
method of estimation) this ratio times the new additional expected sales.

Furthermore, new technology
innovation and the need of imitating
competitors' adoption of innovation
can also force firms to invest, in a process of diffusion that can be
boosted by a conducive tax environment, both in terms of tax breaks and
pro-diffusion-of-innovation tax.

Investment in real
estate new developments and rejuvenation of existing areas are better
understood in operations like urban regeneration.

Impact on other variables

Cumulated investments over time give rise to capital, opening the
path to improvements in production conditions.

Production capacity,
potential productivity, cost effectiveness,
production and process quality will be all increased by properly-oriented
investment. Export competitiveness should
also rise.

Employment
can fall if a labour substitution investment prevails with real output
growing less than physical productivity. By contrast, other kinds of investment
and economic situations give rise to an increasing employment.
The quality and composition of employment also depend on the investment
directions. For instance, green jobs significantly depend on wide investment
in green sectors and technologies.

As a GDP component
from the current domestic expenditure side, investment has an immediate
impact on GDP. An increase of consumption rises
GDP by the same amount, other things equal. Moreover, since income
(GDP) is an important determinant of consumption, the increase of income
will be followed by a rise in consumption:
a positive feedback loop has been triggered
(between consumption and income) by investment.

Because of this mechanism,
imports will grow as well. More directly,
investment is often directed to foreign machineries and goods, with an
immediate increase of imports.

Long-term
trends

Countries differ a lot in respect to investment levels and dynamics. Some
countries have heavily invested, sacrificing current consumption and triggering
an export-led growth, often based
on manufacturing. Others keep investment at much lower levels with an
unsecure growth path.

A
large-scale investment effort in clean technologies and processes is seen
as a conditions for coping with climate change. The our book on "Innovative
Economic Policies for Climate Change Mitigation" puts forth the
proposal of a closed long-term fund to influence investment decisions
of private and public bodies.

Business
cycle behaviour

With its short and violent fluctuations, investment is a clear
source of the business cycle.

On the contrary, the
influence of interest rates on investment can be important at turning
points. At peaks, consistent increase of the interest rate would drastically
worsen the costs of existing loans for past investment. Disappointment
from demand grow may combine with this effect to reduce investment dynamics.

At trough, low interest
rates may be one of the very few good news for firms. Thus, combined with
positive expectations, investment may start growing from the very low
level at which they were.

Positive expectations
toward the economy may also bring leading firms to invest earlier than
the trough. In so doing they may even invert the business cycle.

On the other hand,
investment in machinery may instead follow the lower trough, since the
first recovery may simple use the existing,
not-fully exploited capital.

Changes in government,
with opposition going to the power, can exert an important effect on raising
or abating the expectation of business in terms of the overall economic
environment and for specific actions.

Needless to say, business
cycles have many sources and paths, thus wide discrepancies with the previously
presented scenario can arise.